DP6997 Real Wage Inequality

Author(s): Enrico Moretti
Publication Date: October 2008
Keyword(s): cost of living, general equilibrium, return to education
JEL(s): J01
Programme Areas: Labour Economics, Public Economics
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=6997

A large literature has documented a significant increase in the return to college over the past 30 years. This increase is typically measured using nominal wages. I show that from 1980 to 2000, college graduates have increasingly concentrated in metropolitan areas that are characterized by a high cost of housing. Therefore, the increase in the college premium in real terms may be smaller than the increase in the nominal terms. To measure the college premium in real terms, I deflate nominal wages using a new CPI that allows for changes in the cost of housing to vary across metropolitan areas and education groups. I find that half of the documented increase in the return to college between 1980 and 2000 disappears when I use real wages. To understand the implications of this finding for changes in well-being inequality I use a simple general equilibrium model. It is possible that the relative supply of college graduates increases in expensive cities because college graduates are increasingly attracted by amenities located in those cities. In this case, there may still be a significant increase in well-being inequality even if the increase in real wage inequality is limited. Alternatively, it is possible that the relative demand of college graduates increases in expensive cities due to shifts in the relative productivity of skilled labor. In this case, the relative increase in skilled workers' standard of living is offset by higher cost of living. The empirical evidence indicates that relative demand shifts are more important than relative supply shifts, suggesting that the increase in well-being inequality between 1980 and 2000 is smaller than the increase in nominal wage inequality.